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Tuesday, May 3, 2011

WACC, beta (or market) risk, within-firm (or corporate) risk

9-2 How can be the WACC an average cost? A marginal cost?

Weighted Average cost of capital is average of the cost of debt, equity, and preferred stock. To calculate WACC, the percentages of those securities that contribute on company’s cost of capital are multiplied by their own cost. Sum of all those multiplied is weighted average cost of capital.

WACC is calculated by taking weighted average of the various components’ costs, therefore, is considered as average cost. In other word, WACC is average of the cost of all the sources of finance that company use to raise the finance.

9-3 How would each of the following affect a firm’s cost of debt, rd(1-t); its cost of equity, rs; and its weighted average cost of capital, WACC? Indicate by a plus (+), a minus (-), or a zero (0) if the factor would rise, lower, or have an indeterminate effect on the item in question. Assume other things are held constant. Be prepared to justify your answer, but recognize that several of the parts probably have no single correct answer; these questions are designed to stimulate thought and discussion.

Effect on

Rd (1 – T)

rs

WACC

a.The corporate tax rate is lowered

(+)

(0)

(+)

b.The federal Reserve tightens credit

(+)

(+)

(+)

c.The firm uses more debt

(+)

(+)

(+)

d.The firm doubles the amount of capital it raises during the year.

(+ or 0)

(+or 0)

(+ or 0)

e.The firm expands into a risky new area

(+)

(+)

(+)

f.Investors become more risk averse

(+)

(+)

(+)

a.When corporate tax rate is lowered cost of debt after tax increase while cost of equity does not have any effect and WACC will increase as cost of debt increase.

b.When federal reserve tightens credit, cost of debt increase as in the economy few funds are available hence increase interest rate as well as cost of debt, equity, and WACC.

c.When the firm uses more debt, firm’s capital structure consists of more debt and hence seems more risky. It increases cost of debt, equity, WACC.

d.When the firm doubles the amount of capital raise within a year cost of debt, cost of equity and WACC may increase or remain the same depending on purpose of raising the fund. In most of the case when company doubles its capital WACC, cost of debt and cost of equity tend to increase.

e.When firm expands its business into risky area its cost of capital, cost of equity and WACC increase because of the variability in return.

f.When investors become more risk averse cost of debt, cost of equity and WACC increase as it increases the interest rates.

9-4 Distinguish between beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why?

Beta is a measurement of company’s risk relative to market risk or systematic risk. Beta also measure the risk associated with specified securities or portfolio. In capital assets pricing model theory, securities or portfolios expected return is calculated based on that securities beta. The beta of market is always 1 and if the company is highly risky than that company’s beta is always higher than 1 representing high risk company and hence has higher expected return; while if the company is less risky than company’s beta is less than 1 representing lower risk company and hence has lower expected return.

Corporate (within – firm) risk is a risk associated with individual company. This risk consists of variability of projects return that contributes to corporation’s return. If all the projects that company operate have flexible return then company’s within-firm risk is higher.

Stand-alone risk is the variability of project’s expected return. More risky the project is, the higher flexibility of expected return of that project. Stand-alone risk is more powerful. If stand-alone risk is very high or projects return is highly volatile and it affects the return of other assets of the company or other assets in the economy then it will affect corporate as well as market risk. However, if stand-alone risk of project is higher but not correlated with the return of other assets of the company then it does not affect corporate risk.

Of the three measures, market risk is theoretically most relevant because market risk has direct effect on stock prices and hence reflects the changes on economy as a whole.

9-5 supposes a firm estimates its cost of capital for the coming year to be 10%. What might be reasonable costs of capital for average-risk, high-risk, and low –risk projects?

If firm estimates its cost of capital depending on riskiness of the projects then it is known as risk-adjusted cost of capital. Suppose a firm estimates its cost of capital 10% for coming year then cost of capital for average-risk project would be 10%, cost of capital of high-risk project would be higher than 10%, and cost of capital of low-risk project would be lower than 10%. For example, if cost of capital of firm is 12% then average-risk project will have cost of capital of 12%, high-risk project will have cost of capital of 15%, and low-risk project will have cost of capital of 9%.

This approach is better and well manages than no risk adjustment but in real practice it is very hard to specify exact risk as well as exact cost of capital. Therefore is approach is subjective and vary from firm to firm.